A Victory for Taxpayers and the Economy

This afternoon,
President George W. Bush signed the Tax Increase Prevention and
Reconciliation Act of 2005 (H.R. 4297), which Congress passed last
week. His signing assures that millions of taxpayers and millions
more workers and business owners will enjoy low tax rates on
capital gains and dividends and a potentially stronger economy
through 2010. Had the President not signed this legislation into
law, taxes would have increased in 2009, and the cost of capital, a
key factor for economic growth, would have risen.

Under current law,
individual long-term net capital gains realizations and qualified
dividend income are taxed at preferential rates. Taxpayers in the
lowest two tax brackets pay a 5-percent tax rate on capital gains
and dividend income through 2007 and no taxes on capital gains and
dividend income in 2008. Taxpayers in all other brackets pay a
15-percent tax rate on capital gains and dividend income through
2008.

These preferential
rates are an important part of The Jobs Growth Tax Relief and
Reconciliation Act (JGTRRA) of 2003. Along with JGTRRA's partial
expensing provisions, they have played a role in helping spur
economic activity by boosting disposable income and business fixed
investment. JGTRRA's preferential tax rates on capital gains and
dividend income were set to expire at the end of 2008.[1]
The bill signed by President Bush today extends JGTRRA's
preferential rate structure for capital gains and dividend income
through the end of 2010.[2]
But this is not a complete victory for taxpayers: taxes on both
types of capital income will revert to their pre-JGTRRA levels in
2011.[3]

Economic Effects of
H.R. 4297's Capital Gains and Dividend Provisions

Extending JGTRRA's
preferential rate structure on capital gains and dividend income
will have small-but positive-effects on both gross domestic product
(GDP) and employment. Personal consumption and business fixed
investment are also likely to post modest gains as a result of
H.R.4297. These gains will be modest because H.R. 4297 is only a
temporary extension of an expiring provision. Real GDP,
consumption, and investment would all respond far more positively
to a permanent extension of JGTRRA's preferential tax rates on
capital gains and dividend income.

H.R. 4297's
capital gains and dividend provisions are likely to influence
economic activity through two primary channels. They will increase
personal disposable income by lowering federal tax payments. And
they will reduce the cost of capital to businesses by raising the
value of U.S. equities. Higher personal disposable income is likely
to provide an immediate boost to economic activity. The lower cost
of capital is likely to provide economic benefits over the medium
term.

Most immediately,
H.R. 4297's capital gains and dividend provisions will lower income
tax payments. The Joint Committee on Taxation (JCT) estimates that
extending JGTRRA's rate structure on capital gains and dividend
income will reduce federal tax revenues by a total of some $18
billion in fiscal years 2009 and 2010 and over $50 billion between
fiscal years 2008 and 2016.[4]

Increases in
personal disposable income will likely exceed JCT's estimates of
the revenue effects of extending JGTRRA's preferential rate
structure. This is because JCT's conventional revenue estimates
ignore the influence of tax policy on macroeconomic behavior and
aggregates. However, households are likely to allocate some part of
H.R. 4297's tax cuts to higher personal consumption. Higher
personal consumption is, in turn, likely to encourage businesses to
increase output, investment, and staffing in the short run. Center
for Data Analysis (CDA) analysts considered the feedback effects of
higher personal disposable income on consumption, employment, and
incomes. As a result of those feedbacks, total gains in personal
disposable income could exceed JCT's revenue estimates by several
billion dollars.[5]

The impact of H.R.
4297's capital gains and dividend provisions on the cost of capital
is likely to boost personal consumption and business fixed
investment over the medium term. This effect is likely to be
largest for the extension of JGTRRA's preferential tax rates on
capital gains realizations.

A cut in tax rates
on capital gains influences the cost of capital through two
channels. First, lower capital gains tax rates reduce the
before-tax rate of return businesses must pay investors, making it
possible for businesses to expand their operations.[6]
Second, lower tax rates on capital gains provide firms with a
greater incentive to retain their earnings, thus increasing the
firms' market value. An increase in the market value of firms
translates into an increase in the value of equity markets. This
positive effect of lower capital gains tax rates on equity markets
may be offset to some extent by lower tax rates on dividend
income.

For firms, lower
tax rates on capital gains and dividends can imply a reduction in
the cost of financing new investments with equity. In 2003
congressional testimony, R. Glenn Hubbard, then Chairman of the
President's Council of Economic Advisors, estimated that the
Administration's 2003 Jobs and Growth Initiative could reduce the
corporate sector's cost of capital for equity-financed equipment
investment by more than 10 percent.[7]
Kevin Hassett of the American Enterprise Institute independently
estimated that the Administration's proposal would reduce the cost
of new equipment investment by 4 percent to 7 percent.[8]

Such reductions in
the cost of capital encourage businesses to invest more. CDA
analysts assume somewhat smaller reductions in the cost of equity
finance.[9]
Nevertheless, they project modest gains in both real
non-residential investment and the economy's stock of capital from
2009. Concomitant with an increase in the economy's capital stock
is an increase in its potential output.

For consumers,
lower tax rates on capital gains and dividends imply an increase in
the value of equities and wealth. In a frequently cited study by
the American Council for Capital Formation, the Standard and Poor's
chief economist, David Wyss, attributes about 7.5 percent of the
increase in the S&P 500 between 1997 and 1999 to the 1997
Taxpayer Relief Act's (TRA 97) lower tax rates on capital gains.[10]
In a reduced-form calculation, James Poterba estimates that
JGTRRA's 2003 dividend tax cuts could increase aggregate U.S.
equity values by about 6 percent.[11]
Economic theory suggests that such increases in equity wealth will
encourage higher personal consumption (a "wealth effect").

CDA analysts
assume smaller increases in the value of U.S. equities (as measured
by the value of the S&P 500 index of common stocks) than do
Wyss and Poterba.[12]
For Poterba's calculation, this is in large part because there is
some dispute in the economics literature regarding the magnitude of
the impact of dividends tax cuts on equity values. Under the "new"
view of the economic effects of dividends, the value of equities
rises permanently.[13]
Under the "old" view, that same increase in the value of U.S.
equities is phased out over time.

The economics
literature does not uniformly support one view over another. For
example, Alan Auerbach and Kevin Hassett find that a change in
dividend taxes-particularly a permanent change in dividend
taxes-could have a significant effect on equity markets.[14]
However, a Federal Reserve Board working paper, using a methodology
similar to that of Auerbach and Hassett, found little evidence that
cuts in capital taxation have boosted U.S. equity prices.[15]
CDA analysts took this ambiguity in the literature into account
when analyzing the cost-of-capital effects of H.R. 4297's dividend
provision.

A Step in the Right
Direction

H.R. 4297's
capital gains and dividend provisions are a step in the right
direction. Extending JGTRRA's preferential rate structure on
capital gains and dividend income will help spur economic
activity.

Most immediately,
higher personal disposable income is likely to boost personal
consumption, encouraging businesses to increase investment spending
and staffing to meet higher demand in the short term. Farther out,
lower costs of capital and higher U.S. equity values could bolster
both personal consumption and business fixed investment. Higher
business fixed investment will, in turn, raise both the economy's
capital stock and its potential output.

However, any gains
in real GDP, personal consumption, and business investment spending
are likely to be modest. This is because H.R. 4297's capital gains
and dividend provisions are only temporary. Real GDP, consumption,
investment would all respond more positively to a permanent
extension of JGTRRA's preferential tax rates on capital gains and
dividend income.

[1] H.R. 4297 includes
section-179 expensing provisions. However, this paper only
considers the economic effects of H.R. 4297's capital gains and
dividend provisions.

[2] All estimates of the
revenue effects of the tax reconciliation bill are taken from Joint
Committee on Taxation, "Estimated Revenue Effects of the Conference
Agreement for the 'Tax Increase Prevention and Reconciliation Act
of 2005,'" JCX-18-06, May 9, 2006, at /static/reportimages/BB228F97E8FD5B35B495FA8DD13B8910.pdf.

[3] With no further
extension of JGTRRA's preferential rates, dividend income would be
taxed at ordinary income tax rates starting in 2011. Capital gains
realizations would be taxed at a pre-JGTRRA maximum rate of 10
percent or 20 percent starting in the same year. The 10-percent
rate applies to all taxpayers in the lowest (15-percent) tax
bracket. The 20 percent rate applies to taxpayers in all other tax
brackets.

[4] See Joint Committee on
Taxation, "Estimated Revenue Effects of the Conference Agreement
for the "Tax Increase Prevention and Reconciliation Act of 2005,"
JCX-18-06, May 9, 2006, at /static/reportimages/BB228F97E8FD5B35B495FA8DD13B8910.pdf. JCT is
officially charged with estimating the "static" revenue effects of
proposed changes in tax policy. Such static (or conventional)
revenue estimates may include the microeconomic effects of changes
in tax policy on federal receipts. However, they exclude the
macroeconomic effects of changes in tax policy on labor force
participation, saving, interest rates, etc. "Dynamic" revenue
estimates include these macroeconomic effects. They can differ,
sometimes substantially, from static revenue estimates that assume
that changes in tax policy have no effect on macroeconomic behavior
or aggregates. Rough dynamic revenue estimates show small-but
positive-revenue feedbacks from H.R. 4297's capital gains and
dividend provisions.

[5] The Global Insight
short-term U.S. Macroeconomic Model is used to help gauge the
economic-and-budgetary effects of enacting the capital gains and
dividend provisions of H.R. 4297. CDA analysts begin with a version
of the Global Insight model that has been calibrated to the
Congressional Budget Office's January 2006 baseline economic and
budgetary projections. The methodologies, assumptions, conclusions,
and opinions in this analysis have not been endorsed by and do no
reflect the views of the owners of the Global Insight model.
Fortune 500 companies and numerous government agencies use Global
Insight's short-term U.S. macroeconomic model to forecast how
changes in the economy and in public policy are likely to impact
major economic indicators.

[9] CDA analysts estimate
that the drop in the cost of equity finance attributable to H.R.
4297's capital gains provision ranges from just over 1 percent to
almost 4 percent. They attribute a much smaller potential decline
in the cost of equity finance to H.R. 4297's dividend
provision.

[10] For example, see Margo
Thorning, "Capital Gains Taxation and US Economic Growth,"
Testimony before the Standing Committee on Banking, Trade and
Commerce of the Senate of Canada, December 16, 1999, at http://www.accf.org/publications/testimonies/
test-dec16-99.html. Alternatively, Shackelford, et al. examine
the effects of personal capital gains taxation on asset prices in
the period surrounding the announcement of TRA 97's capital gains
tax cuts. Their analysis incorporates both the demand-side
capitalization effects and the supply-side lock-in effects of a
change in the capital gains tax rate. Shackelford, et al. find
evidence of initial price declines (a capitalization effect),
followed by price increases after the official announcement of TRA
97's cuts in the tax rate on capital gains (a lock-in effect).
Their results are still tentative but seem to suggest that the two
effects approximately offset one another. See Shackelford, et al.,
"Capital Gains Taxes and Asset Prices: Capitalization or Lock-in?,"
February 16, 2006, at /static/reportimages/3A33589A0AAA4CF938263B80ED2F10A2.pdf.

[11] See James Poterba,
"Taxation and Corporate Payout Policy," National Bureau of Economic
Research, Working Paper No. 10321, February 2004, at http://www.nber.org/W10321. Poterba obtains this 6
percent estimate by using an S&P 500 price-earnings ratio to
capitalize CBO projections of the annual flow of foregone dividend
taxes.

[12] CDA analysts derive
estimates of changes in the S&P 500 using an equation that
links changes in S&P 500 dividends and the maximum capital
gains tax rate to changes in the cost of equity. CDA analysts
obtain a static estimate of the change in the cost of equity using
a separate equation for the after-tax rental price of capital. That
equation expresses the after-tax price of-or return to-equity as a
weighted average of the after-tax return to dividends and the
after-tax return to capital gains. An explicit expression for the
after-tax return to equity is obtained by equating that weighted
average with the after-tax return to corporate debt.

[13] For a more detailed
description of the treatment of the old and new views of the
economic effects of dividends in macroeconomic models, see Ben
Page, "How CBO Analyzed the Macroeconomic Effects of the
President's Budget," Congressional Budget Office, July 2003, at /static/reportimages/A6294150E32A048935B56896E2B2581D.pdf.

[14] See Alan J. Auerbach
and Kevin A. Hassett, "The 2003 Dividend Tax Cuts and the Value of
the Firm: An Event Study," National Bureau of Economic Research,
Working Paper No. 11449, June 2005, at http://www.nber.org/papers/W11449.